6.2 Characteristics of bonds and equities

that the costs of entry are too high for small and medium-size rms. From 1980 to

1996 the LSE was supplemented by the Unlisted Securities Market (USM), which had

lower listing requirements. The two were merged in 1996 when European Community

directives, intended to harmonise listing requirements across Europe, lowered the

criteria for access to the LSE to the point where there was little difference between

the LSE and the USM. The need for a subsidiary market with less demanding criteria

and lower entry costs did not disappear, however. Since 1995, this has been provided

by the Alternative Investment Market or AIM.

A less dramatic case than that of rms seeking an initial listing arises when rms

which are already listed, and whose shares are already widely owned, wish to issue

more shares in order to nance an expansion. This involves what is called a rights

issue, since existing shareholders must be given the right to buy the new shares in

proportion to the size of their existing shareholding. Behind this lies the view that

a shareholder in any company should be able to protect his proportionate share in

the company: this should not be diluted unless the shareholder so decides. He can

so decide by declining to take up his rights to the new shares by selling the rights.

In all cases, whether it is a rm seeking to go public for the rst time or a rm making

a rights issue, the issue of new shares will normally be managed by an issuing house,

usually an investment bank which specialises in this activity. The issuing house charges

a fee for handling the publicity and administration of the sale and for advising the

rm about the price of the shares and the timing of the sale. With the exception of

rights issues, new issues will usually be underwritten by the issuing house. This

means that it guarantees the company that the desired funds will be raised, even if

some of the shares remain unsold. In these circumstances, it takes up the shares itself

or, in the case of a large issue, it arranges in advance with other investment banks

that they will collectively take up any unsold stock.

There are various ways of marketing new issues. The simplest is the offer for sale,

where an issuing house buys the whole of the issue at an agreed price and then resells

the shares to the general public, over a period of time, for the best price that it can

get. An offer for sale by tenderis similar except that the general public is invited to

make a bid for the shares subject to a minimum specied price. Tenders are ranked

in descending order of price and the lowest price is identied at which the whole

issue would sell out. All bidders above that price are then allotted shares at that price

(the striking price) regardless of the price they may have bid. A placinginvolves the

issuing house placing the shares with investors, usually the large institutions, whom

it knows will be interested in the type of share in question.

However, trading in the primary market is dwarfed by the buying and selling of

existing shares. And it is this activity that is widely reported in the media every day.

The scale of the difference between new issue activity, where new funds are raised,

and turnover in existing equities can be seen in Table 6.2. This shows that in 2005,

UK corporations raised £18,692m by issuing new shares in London, while the turn-

over in existing company shares was approximately 25 times as large.

Given the overwhelming magnitude of transactions in existing shares when com-

pared with activity which raises new funds, it is easy to dismiss the activities of stock

exchanges as little more than a form of gambling. Undoubtedly, there are many

161

....

FINM_C06.qxd 1/18/07 11:32 AM Page 162

Chapter 6

• The capital markets Table 6.2Ordinary company shares, new issues and turnover, 2005, £m

New issues of ordinary company shares1
	18,692

Turnover in ordinary	shares	by:
Pension funds			155,876
Life assurance			140,985
Investment trusts			18,035
Unit trusts			154,425
Total			469,321

New issues: turnover

0.04

¹Before redemptions. (UK rms only).

Source: ONS, Financial Statistics, March 2006, Tables 5.3a and 6.2a

investors whose only interest lies in the secondary market and only then in what is

going to happen to selected share prices in the short run. However, while the motives

of some may be greed and little else, the combined activities of all may mean that

stock market performance is both important to us all and generally benecial from

an economic point of view. We have already mentioned some of the consequences:

l	An active stock market transforms equities from being a very long-term form of investment into highly liquid assets. This undoubtedly increases the availability of long-term funds to rms and reduces the cost.

l

If individual share prices generally reect the performance of their rms, then successful, well-managed rms will have a high share price and a high market value. Poorly performing rms will be valued accordingly. A depressed share price usually makes a rm a target for takeover. In a takeover, the management of the target rm is usually replaced and thus one might argue that an active stock market is one way of promoting the efcient management of rms.

l	Changes in the general level of share prices affect people’s wealth, directly (for shareholders) and indirectly (for those with pensions and life assurance policies). They also affect consumers’ and rms’ condence. A booming stock market rein- forces a booming economy and vice versa.

l

When share prices are high, new issues can be made at a high price. This brings in a large volume of new funds for each additional dividend payment that a rm is committing itself to in future. The cost of new capital, in other words, is low. The cost of capital is high when share prices are low. It may be true that little capital is raised through new issues (compared with retained prot, for example), but even when using retained prot to nance new investment projects, a rational, prot-maximising rm should still be evaluating new projects in the light of the cost of capital. Internal funds are not free. They have an opportunity cost which is the return they could have earned by being invested elsewhere, including invest- ment in the shares of other rms.

Like the bond market that we looked at above, the secondary market for com-

pany shares was dramatically affected by the Big Bang reforms of 1986, and the

162

....

FINM_C06.qxd 1/18/07 11:32 AM Page 163